Module/Unit I: Part 2 - Basic Cost Management Concepts antonio jaramillo dayag

What is a Cost?

A ______ is a sacrifice of resources. In buying one thing, we give up (sacrifice) the ability to use these
resources (typically cash or an credit line) to buy something else. The price of each item measures the
sacrifice we must make to acquire it. Whether we pay cash or use another asset, whether we pay now or
later, the cost of the item acquired is represented by what we forgo as a result.

Costs are assigned to cost objects for a variety of purposes including pricing, preparing profitability
studies, and controlling spending. A ____________ is anything for which cost data are desired—including
products, customers, jobs, and organizational subunits.

Cost versus Expenses

It is significant to differentiate cost from expense. An _________ is a cost charged against revenue in an
accounting period; hence, expenses are deducted from revenue in that accounting period. _______ were
incurred whenever we give up (sacrifice) resources, regardless of whether we account for it as an asset or
an expense.

We may even incur costs that the financial accounting system never records as an asset or expense. An
example is lost sales. If the cost is recorded as an asset (for example, prepaid rent for an office building),
it becomes an expense when the asset has been consumed (i.e., the building has been used for a period of
time after making the prepayment).

In this textbook, we use the term expense only when referring to external financial reports. The focus of
cost accounting is on costs, not expenses.

Generally accepted accounting principles (GAAP) and regulations such as the income tax laws specify
when costs are to be treated as expenses. Although the terms cost and expenses are sometimes used as
synonyms in practice, we use cost in this book for all managerial purposes.

Cost Assignment: Direct Tracing, Driver Tracing, and Allocation

To study cost accounting, it is necessary to understand the meaning of cost and to become familiar with
the cost terminology associated. One must also understand the process used to assign costs.

_______________ is one of the key processes of the cost accounting system. Improving the cost assignment
process has been one of the major developments in the cost management field in recent years. Before
discussing the cost assignment process, we first need to define what we mean by cost.

_______ is the cash or cash equivalent value sacrificed for goods and services that are expected to bring a
current or future benefit to the organization. Cash equivalent was mentioned because noncash assets can
be exchanged for the desired goods or services. For instance, it may be possible to exchange machinery
for materials used in production. Costs are incurred to produce future benefits.

__________ are called as expired costs. As costs are used up in the production of revenues, they are said
to expire In a profit making firm, future benefits usually mean revenues. In each period, expenses are
deducted from revenues on the income statement to determine the period’s profit.

A _______ is a cost that expires without producing any revenue benefit. For example, the cost of
uninsured raw materials destroyed by a fire would be classified as a loss on the income statement.

Many costs do not expire in a given period. These unexpired costs are classified as assets and appear on
the balance sheet. Buildings and equipment are examples of assets lasting more than one year.

Note that the main difference between a _____ being classified as an ________ or as an ______ is timing.
This distinction is significant and will be referred to in the expansion of other cost concepts to be discuss
in succeeding chapter.

The manufacturing process requires the conversion of raw materials into finished goods through the use
of labor and factory overhead. Companies must make a major investment in physical assets, such as
property, plant, and equipment. To produce finished goods, a manufacturer must purchase proper
quantities of materials and supplies, and improve a employees conditioning such as labor cost. In
addition to the cost of materials and labor cost, the manufacturer incurs other expenses in the
manufacturing process.
Many of these costs, such as depreciation, taxes, insurance, and utilities, are similar to those incurred by
a merchandising concern. Costs such as machine maintenance and repair, materials handling,
production setup, production scheduling, and inspection are unique to manufacturers. Other costs, such
as selling and administrative expenses, are similar to those incurred by merchandisers and service
businesses. The methods of accounting for sales, cost of goods sold, and selling and administrative
expenses for a manufacturer are similar to those of merchandisers. Service businesses, by comparison,
have no inventories because the service is consumed at the time it is provided. Service businesses have
revenue and operating expenses, but no cost of goods sold.

Cost Objects

Management accounting systems are structured to measure and assign costs to cost objects.
A ______________ is any item, such as products, customers, departments, projects, activities, and so on,
for which costs are measured and assigned.
For instance, if we want to determine what it costs to produce a car, then the cost object is the car. If we
want to determine the cost of operating a assembly department within a plant, then the cost object is the
assembly department. If we want to determine the cost of developing a new cellphone, then the cost
object is the cellphone scheme. As a final example, activities should be mentioned.
An __________ is within an organization wherein a basic unit of work will be done. An activity can also
be defined as an accumulation of activities within an organization useful to leaders for purposes of
planning, controlling, and decision making. Activities are considered as cost objects.

Activities play a prominent role in assigning costs to other cost objects and are essential elements of an
activity-based management accounting system. Examples of activities include setting up machinery for
manufacturing, transferring materials and goods, buying parts, customers billing and payment,
maintenance service, expediting procurement, products designing, and product inspection.

Accuracy of Assignments
_____________________ to cost objects accurately is too crucial. Notion of accuracy is not evaluated based
on knowledge of some underlying “real” cost. Rather, it is a relative concept and has to do with the
rationality of the cost assignment methods that are being used.

The objective is to measure and assign as accurately as possible the cost of the resources used by a cost
object. Some cost assignment methods are simply more precise than others.

A _____________ is anything for which a separate measurement of costs is desired. Examples include a
product, a service, a project, a customer, a brand category, an activity, and a department.

Classification of Costs
I. Traceability
_______________ of a cost object are related to the particular cost object and can be traced to that cost
object in an economically feasible (cost-effective) way.
_____________________ of a cost object are related to the particular cost object but cannot be traced to
that cost object in an economically feasible (cost-effective) way.
_________________ is a general term that encompasses the assignment of both direct costs and indirect
costs to a cost object.
Direct costs are traced to a cost object while indirect costs are allocated to a cost object.
The relationship of costs to cost objects can be exploited to help increase the accuracy of cost
assignments. Costs are directly or indirectly associated with cost objects.

_______________ are those costs that can be traced easily and accurately to a cost object. On the other
hand, ________________ are costs that cannot be traced easily and accurately to a cost object

For costs to be traced simply means that the costs can be allotted in an economically reasonable way. For
costs to be traced correctly means that the costs are allotted using a causal relationship.

Thus, ______________ is simply the capability to assign a cost directly to a cost object in an economically
feasible way by means of a causative relationship. The more costs that can be traced to the object, the
greater the correctness of the cost assignments.

Establishing traceability is a key component in constructing accurate cost assignments. One extra point
needs to be emphasized. Cost management systems naturally deal with many cost objects.

Thus, it is conceivable for a particular cost item to be classified as both a ______________ and
an_______________ . It all depends on which cost object is the point of reference. For example, if the
factory house is the cost object, then the cost of heating and cooling the factory house is a direct cost;
however, if the cost objects are products manufactured in the factory house, then this utility cost is an
indirect cost.
 I – Association with Cost Object
Espana University’s College of Business has five departments: Accounting, Economics, Finance,
Management, and Marketing. Each department chairperson is responsible for the department’s budget
preparation. Indicate whether each of the following costs incurred in the Accounting Department is
direct or indirect to the department:
Cost Item
1. Accounting faculties salaries
2. Accounting chairperson’s salaries
3. Cost of computer time of university server used by members of the dept.
4. Cost of office assistant salaries (office salaries are shared by the entire college)
5. Cost of travel by department faculty paid from externally generated funds contributed
directly to the department
6. Cost of equipment purchased by the department
7. Depreciation allocation of the college building cost for the number of offices used by dept.
faculty
8. Cost of periodical/books purchased by the department
9. Cost of software on faculty computers
Methods of Tracing
Traceability means that costs can be assigned easily and accurately, using a causal relationship.
Tracing costs to cost objects can occur in one of two ways:
1. direct tracing and
2. driver tracing
________________ is the process of recognizing and allocating costs to a cost object that are exactly or
physically associated with the cost object. Identifying costs that are exactly associated with a cost object
is most often accomplished by physical observation.
For instance:
 Assume that the power department is the cost object. The salary of the power department’s
supervisor and the fuel used to produce power are examples of costs that can be specifically
identified (by physical observation) with the cost object (the power department).
 As a second example, consider a pair of blue jeans. The materials (denim, zipper, buttons, and
thread) and labor (to cut the denim according to the pattern and sew the pieces together) are
physically observable; therefore, the costs of materials and labor can be directly charged to a pair
of jeans. Ideally, all costs should be charged to cost objects using direct tracing. Unfortunately, it
is often not possible to physically observe the exact amount of resources being consumed by a
cost object.

The next best method is to use cause-and-effect relationship to identify the cost objects -called drivers -
that can be detected and which measure a cost object’s resource consumption.

__________ are factors that cause changes in resource usage, activity usage, costs, and revenues.
_______________ is the use of drivers to assign costs to cost objects. Although less precise than direct
tracing, driver tracing is very accurate if the cause-and-effect relationship is sound.

For instance, consider the cost of electricity for the jeans manufacturing plant. The factory manager
might want to know how much electricity is used to run the sewing machines. Physically observing how
much electricity is used would require a meter to measure the power consumption of the sewing
machines, which may not be practical. Thus, a driver such as “machine hours” could be used to assign
the cost of electricity. If the electrical cost per machine hour is P0.50 and the sewing machines use
20,000 machine hours in a year, then P10,000 of the electricity cost (P0.50 x 20,000) would be assigned
to the sewing activity.

Assigning Indirect Costs

_________________ are not traceable to cost objects. This means that there is no causal connection
between the cost and the cost object, or that tracing is not economically realistic. Assignment of indirect
costs to cost objects is called ____________ . Since no causal relationship exists, allocating indirect costs is
based on convenience or some assumed linkage.

For instance, consider the cost of heating and lighting a plant that manufactures five products. Suppose
that this utility cost is to be assigned to the five products. Clearly, it is difficult to see any causal
relationship. A convenient way to allocate this cost is simply to assign it in proportion to the direct labor
hours used by each product. Arbitrarily allocating indirect costs to cost objects reduces the overall
accuracy of the cost assignments. Accordingly, the best costing policy may be that of assigning only
traceable direct costs to cost objects. However, it must be admitted that allocations of indirect costs may
serve other purposes besides accuracy. For example, allocating indirect costs to products may be
required for external reporting. Nonetheless, most managerial uses of cost assignments are better served
by accuracy. At the very least, direct and indirect cost assignments should be reported separately.
Cost Assignment Summarized
The foregoing discussion reveals three methods of assigning costs to cost objects:
1. direct tracing,
2. driver tracing, and
3. allocation

Of the three methods, _______________ is the most precise since it relies on physically observable causal
relationships. Direct tracing is followed by driver tracing in terms of cost assignment accuracy. Driver
tracing relies on causal factors called drivers to assign costs to cost objects.

The precision of driver tracing depends on the strength of the causal relationship described by the
driver. Identifying drivers and assessing the quality of the causal relationship is much more costly than
either direct tracing or allocation. In fact, one advantage of allocation is that it is simple and inexpensive
to implement.

However, allocation is the least accurate cost assignment method, and its use should be avoided where
possible. In many cases, the benefits of increased accuracy by driver tracing outweigh its additional
measurement cost. This cost-benefit issue is discussed more fully later in the chapter. What the process
really entails is choosing among competing cost management systems.

II. Behavior
A _________________ changes in total in proportion to changes in the related level of total activity or
volume. An example is a sales commission that is a percentage of each sales revenue peso.

A _______________ remains unchanged in total for a given time period, despite wide changes in the
related level of total activity or volume. An example is the leasing cost of a machine that is unchanged
for a given time period (such as a year) regardless of the number of units of product produced on the
machine.

A __________________ (perhaps better called as mixed costs) contain both fixed and variable and it vary
in total amount but not in direct proportion to output or activity. Instead of increasing at a constant rate,
semivariable cost tends to either increase at an increasing rate or increase at a decreasing rate.

An example of semivariable cost that increase at an increasing rate such as cost of electricity.

_______________ are often called step cost. It increases in lump sum with changes in output or activity
level.

A __________ function displays a constant level of cost for a range of activity output and then jumps to a
higher level of cost at some point, where it remains for a similar range of activity.

Costs that follow a step-cost behavior with narrow steps are defined as ___________ costs.

Costs that follow a step-cost behavior with wide steps are defined as ____________ costs.

A _________________ is a variable, such as the level of activity or volume that causally affects total costs
over a given time span. A change in the cost driver results in a change in the level of total costs. For
example, the number of vehicles assembled is a driver of the costs of steering wheels on a motor-vehicle
assembly line.

The _____________________ is the band of normal activity level or volume in which there is a specific
relationship between the level of activity or volume and the cost in question. Costs are described as
variable or fixed with respect to a particular relevant range.

A ______________ is computed by dividing some amount of total costs (the numerator) by the related
number of units (the denominator). In many cases, the numerator will include a fixed cost that will not
change despite changes in the denominator. It is erroneous in those cases to multiply the unit cost by
activity or volume change to predict changes in total costs at different activity or volume levels.

III. Timing

___________________ are all costs of a product that are considered as assets in the balance sheet when
they are incurred and that become cost of goods sold when the product is sold. These costs are included
in work-in-process and finished goods inventory (they are “inventoried”) to accumulate the costs of
creating these assets.

______________ are all costs in the income statement other than cost of goods sold. These costs are
treated as expenses of the accounting period in which they are incurred because they are expected not to
benefit future periods (because there is not sufficient evidence to conclude that such benefit exists).
Expensing these costs immediately best matches expenses to revenues.
 II – Cost Classification
Classify each of the following costs incurred in manufacturing bicycles as variable (V), fixed, (F), or,
mixed (M) cost (using units produced as the activity measure). Also indicate whether the cost is direct
material (DM), direct labor (DL), or overhead (OH).
Cost Item V or F or M DM, DL, OH
1. Factory supervision
2. Aluminum tubing
3. Rims
4. Emblem (assuming cost is immaterial)
5. Gearbox
6. Straight-line depreciation
7. Fenders
8. Raw materials inventory clerk’s wages
9. Quality control inspector’s salary
10. Handlebars
11. Metal worker’s wages
12. Roller chain
13. Paint (assuming cost is considered material

III – Cost Classification

For each of the following costs incurred in a manufacturing operation, indicate whether the costs would
be fixed or variable (F or V), Product (Pro) or Period (Per) and whether they are Direct to the product or
Indirect to the product concerned
Direct or
Fixed (F) Period (P) Indirect (to
Cost Item Variable (V) Product (R) product)
a. Transportation-in costs on materials
purchased
b. Assembly-line workers’ wages
c. Property taxes on work in process
inventories
d. Salaries of top executives in the
company
e. Overtime premium for assembly
workers
f. Sales commissions
g. Sales personnel
h. Production supervisory salaries
i. Controller’s office supplies
j. Executive office heat and air
conditioning
k. Executive office security personnel
l. Supplies used in assembly work
m. Factory heat and air conditioning
n. Power to operate factory equipment
o. Depreciation on furniture for sales
staff
p. Varnish used for finishing product
q. Marketing personnel health insurance
r. Packaging materials for finished
product
s. Salary of the quality control manager
who checks work on the assembly line
t. Assembly-line workers’ dental
insurance
Product Costs - Service Costs and Manufacturing Costs

One of the most important cost objects is the output of organizations. The two types of output are:
1. ____________ are tasks or activities performed for a customer or an activity performed by a
customer using an organization’s products or facilities. Services are also produced using
materials, labor, and capital inputs. Insurance coverage, medical care, dental care, funeral care,
and accounting are examples of service activities performed for customers. Car rental, video
rental, and skiing are examples of services where the customer uses an organization’s products
or facilities.
2. ____________________ are goods produced by converting raw materials through the use of labor
and capital inputs such as plant, land, and machinery. Televisions, hamburgers, automobiles,
computers, clothes, and furniture are examples of tangible products.
Services differ from tangible products on three important dimensions:
 intangibility,
 perishability, and
 inseparability

______________ means that buyers of services cannot see, feel, hear, or taste a service before it is bought.
Thus, services are _________________.

_______________ means that services cannot be stored (there are a few unusual cases where tangible
goods cannot be stored).

Finally, ________________ means that producers of services and buyers of services must usually be in
direct contact for an exchange to take place. In effect, services are often inseparable from their
producers. For example, an eye examination requires both the patient and the optometrist to be present.
However, producers of tangible products need not have direct contact with the buyers of their goods.
Buyers of automobiles, for instance, never need to have contact with the engineers and assembly line
workers who produce automobiles.

Establishments that produce tangible products are called __________________________. Those that
produce intangible products are called service organizations. Managers of organizations that produce
goods or services need to know how much individual products cost for a number of reasons, including
profitability analysis and strategic decisions concerning product design, pricing, and product mix.

Individual product cost can refer to either a tangible or an intangible product. Thus, when we discuss
product costs, we are referring to both intangible and tangible products.

Different Costs for Different Purposes

A fundamental cost management principle is “Different costs for different purposes.” Thus, what a
particular cost means depends on the managerial objective being served. This principle should not be
used as a justification for proliferation of product costing methods. Product costing methods than
necessary can be confusing and could undermine the credibility of the cost management information
system.

Product cost definitions can differ according to the objective being served.
I. Cost in Relation to the Product Costs/External Financial Reporting/Major Functional
Categories
The process of classifying costs and expenses can begin by relating costs to the different phases in the
operation of the business.

Manufacturing Companies
A manufacturing company has a more complex income statement than do service or merchandising
(retail/wholesale) companies. Financial reporting distinguishes costs in a manufacturing firm based on
when the costs are recognized as expenses on the financial statements.

In the case of manufactured goods, these costs consist of direct materials, direct labor, and
manufacturing overhead. Product costs “attach” to units of product as the goods are purchased or
manufactured and they remain attached as the goods go into inventory awaiting sale. Product costs are
initially assigned to an inventory account on the balance sheet. When the goods are sold, the costs are
released from inventory as expenses (typically called cost of goods sold) and matched against sales
revenue. Because product costs are initially assigned to inventories, they are also known as
inventoriable costs.

We want to emphasize that product costs are not necessarily treated as expenses in the period in which
they are incurred. Rather, as explained above, they are treated as expenses in the period in which the
related products are sold.

For decision making, it is not enough for the manufacturer to know how much it paid for a good; it must
also know the different costs associated with making it.

Costs are subdivided into two major functional categories:

1. manufacturing/production costs and
2. commercial expenses/non-manufacturing/nonproduction/operating expenses

Manufacturing/Production Costs
___________________________________ - also called factory cost—is usually defined as the sum of three
cost elements: direct materials, direct labor, and factory overhead. Direct materials and direct labor
together are called prime cost.

___________________________________ are those costs associated with the manufacture of goods or the
provision of services. Product (manufacturing) costs follow the product through inventory
Production costs can be further classified as direct materials, direct labor, and overhead. Only these
three cost elements can be assigned to products for external financial reporting.

Direct Materials

____________________ are the acquisition costs of all materials that eventually become part of the cost
object (work in process and then finished goods), and can be traced to the cost object in an economically
feasible way.
_________________ are all materials that form an integral part or traceable to the finished goods or
services and that are included explicitly in calculating the cost of the product. Materials that become
part of a tangible product or those materials that are used in providing a service are usually classified as
direct materials.

The materials that go into the final product are called _____________ . This term is somewhat misleading
because it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw
materials refer to any materials that are used in the final product; and the finished product of one
company can become the raw materials of another company.

For example, the boxes produced by computer companies are a raw material used by them in its personal
computers. Raw materials may include both ___________________________.

Examples of direct materials are the lumber to make furniture and the crude oil to make gasoline. The
ease with which the material items can be traced to the final product is a major consideration in
classifying items is direct materials.

For instance, steel in an automobile, wood in furniture, alcohol in cologne, denim in jeans, braces for
correcting teeth, surgical gauze and anesthesia for an operation, ribbon in a bouquet, and food on an
airline are all _________________.

Direct Labor
_______________________ include the compensation of all manufacturing labor that can be traced to the
cost object (work in process and then finished goods) in an economically feasible way.
_____________ is labor that converts direct materials into the finished product and can be traceable or
assigned feasibly (i.e., physically and conveniently) to a specific product. Like direct materials, physical
observation can be used to measure the quantity of labor used to produce a product or service.

Direct labor is sometimes called touch labor because direct labor workers typically touch the product
while it is being made.

Examples of direct labor include assembly-line workers at car manufacturers, carpenters for building
contractors, and electricians who install equipment in a production department

Employees who convert raw materials into a product or who provide a service to consumers are classified
as direct labor. Workers on an assembly line for car manufacturers, a chef in a restaurant, a surgical
nurse for an open-heart operation, and a pilot for an airline are examples of direct labor.

For automated factories, two problems regularly arise:

1. Direct and indirect labor costs are difficult or impossible to separate.
2. Direct labor may be trivial fraction of total production costs, making it difficult to justify
identifying direct labor as a separate cost element.

In settings in which one or both of these circumstances exist, a single conversion cost classification
is appropriate, leaving direct materials as the only cost element traced directly to the product.

Labor costs that cannot be physically traced to specific products, or that can be traced only at excessive
cost and inconvenience, are termed indirect labor. Just like indirect materials, indirect labor is treated
as part of factory overhead. Indirect labor includes the labor costs of janitors, supervisors, materials
handlers, and night security guards. Although the efforts of these workers are essential, it would be
either impractical or impossible to accurately trace their costs to specific units of product. Hence, such
labor costs are treated as indirect labor.

Factory/Manufacturing Overhead
_______________________ are all manufacturing costs that are related to the cost object (work in process
and then finished goods), but cannot be traced to that cost object in an economically feasible way.
________________ are all direct manufacturing costs (direct material and direct manufacturing labor).
_________________ are all manufacturing costs other than direct material costs.
_________________ is the wage rate paid to workers (for both direct labor and indirect labor) in excess of
their straight-time wage rates.
__________________ is a sub-classification of indirect labor that represents wages paid for unproductive
time caused by lack of orders, machine breakdowns, material shortages, poor scheduling, and the like.
___________________ is also called manufacturing overhead, the third element of manufacturing
expenses, or factory burden - consists of all manufacturing costs not traced directly to specific object
except direct materials and direct labor.
Manufacturing overhead includes items such as indirect materials; indirect labor; maintenance and
repairs on production equipment; and heat and light, supplies, taxes on the factory assets, insurance on
the factory building and equipment supervision, materials handling, power, property taxes, landscaping
of factory grounds, and plant security, depreciation of factory building and equipment, and insurance on
manufacturing facilities.
A company also incurs costs for heat and light, property taxes, insurance, depreciation, and so forth,
associated with its selling and administrative functions, but these costs are not included as part of
manufacturing overhead. Only those costs associated with operating the factory are included in
manufacturing overhead.
Various names are used for manufacturing overhead, such as indirect manufacturing cost, factory
expense and factory burden. All of these terms are synonyms for factory overhead/manufacturing
overhead.
Indirect materials are those materials needed for the completion of a product but are not classified as
direct materials because they are not become part of the product or are not used in providing a service.
Indirect materials also include materials that normally would be classified as tracing or complex,
treating them as direct materials becomes futile or uneconomical.
Direct materials that form an insignificant part of the final product are usually lumped into the
overhead category as a special kind of indirect material. This is justified on the basis of cost and
convenience. The cost of the tracing is greater than the benefit of increased accuracy.
Examples include sandpaper used in sanding furniture, paper patterns, and staples, lubricating oils,
grease, cleaning rags, polishing and cleaning materials, repair parts, and light bulbs and supplies such
dishwasher detergent in a fast-food restaurant, oil for production equipment, lumber used in making
furniture, fabric used in the production of clothing, iron ore used in the manufacture of steel products,
rubber used in the production of athletic shoes, fuse used to make electrical connections in a television
company or the nails used to assemble a wood chair, brushes needed to maintain the working area and
machinery in usable and safe condition which are not a part of the finished product but are necessary to
manufacture it, materials that actually become part of the finished product, such as thread, screws,
rivets, nails, and glue, but whose costs are relatively insignificant, making it not cost effective to trace
them to specific products.
________________ is the labor not directly traced to the production or configuration of the finished
product. The employees who are required for the manufacturing process but who do not work directly on
the units being manufactured are considered indirect labor.
This classification includes department heads, inspectors, and wages of supervisors, shop, clerk, general
helpers, materials handlers, inventory storekeepers and maintenance personnel/workers. Payroll-related
costs, such as payroll taxes, group insurance, sick pay, vacation and holiday pay, retirement program
contributions, and other fringe benefits are usually treated as indirect costs.
While only direct materials and direct labor are traced to a particular unit of product, other levels of
traceability are also useful in understanding the nature of _____________________ .
Setup costs are directly traceable to a batch, but are indirect to a single unit in the batch; and so on. This
suggests one of the fundamental tenets of cost accounting: different costs are meaningful and useful for
different purposes.
Some companies, however, more appropriately, treat the fringe benefits paid for direct laborers as
additional direct labor cost for the purpose of precisely determining how much each hour of direct labor
really costs. The cost of overtime for direct labor is usually assigned to overhead as well. The rationale is
that typically no particular production run can be identified as the cause of the overtime. Accordingly,
overtime cost is common to all production runs and is therefore an indirect manufacturing cost. Note
that only the overtime cost itself is treated this way.

If workers are paid an P4 regular rate and a P2 overtime premium, then only the P2 overtime premium
is assigned to overhead. The P4 regular rate is still regarded as a direct labor cost. In certain cases,
however, overtime is associated with a particular production run, such as a special order taken when
production is at 100 percent capacity. In these special cases, it is appropriate to treat overtime premiums
as a direct labor cost.
Most cost accounting systems comprise in factory overhead all costs that are not traceable to a particular
unit or lot. In such systems, the factory costs directly traceable to a batch, client order or an entire
manufacturing facility, a new product or product variation, or a strategic goal are combined in a single
overhead classification, because none of these costs is viewed as being directly traceable to the product.
In a service business, indirect labor cost can include the wages of receptionists, switchboard operators,
file clerks and supply clerks.
Prime and Conversion Costs
The manufacturing and nonmanufacturing classifications give rise to some related cost concepts. The
functional allocation between manufacturing and nonmanufacturing costs is essentially the basis for the
concepts of inventoriable costs and non-inventoriable costs - at least for purposes of external reporting.
Combinations of different production costs also produce the concepts of conversion costs and prime costs.
___________ is the sum of direct materials cost and direct labor cost.
__________________ is the sum of direct labor cost and overhead cost. For a manufacturing firm,
conversion cost can be interpreted as the cost of converting raw materials into a final product.

In some firms, managers give prime costs much attention because they represent majority of total
manufacturing costs. In other cases, managers give most of their attention to __________________, which
are the costs to convert direct materials into the final product. These are the costs for direct labor and
manufacturing overhead. Managers who focus on conversion costs and use a controllability argument
since direct materials costs are mostly outside of control
Normally, entities with relatively low manufacturing overhead focus on managing prime costs.
Companies that have high direct labor and/or manufacturing overhead tend to be more concerned about
conversion costs.
In practice, you have to determine the cost information that decision makers need to manage effectively.
It is not only the relative amount of costs that matters in determining which costs to monitor. The
important issue is identifying the most important costs over which the firm has control.
For example, in some processing firms, the largest costs are the direct materials costs. However, because
those materials are commodities with prices set in well-functioning markets, it may be infeasible to
exercise much control over those costs other than monitoring usage. Exhibit 2.4 summarizes the relation
between conversion costs and the three elements of manufactured product cost: direct materials, direct
labor, and manufacturing overhead.

Trading/Merchandising (Retail and Wholesale) Organizations

In buying merchandise for sale, there are purchased from a retailer (or maybe a wholesaler) firm.
Trading or merchandising firms sell but do not make a tangible product. The income statement for these
companies includes revenue and cost items as does that for service companies, but for retailers and
wholesalers, it has an added category of cost information (called cost of goods sold/cost of sales) to track
the cost of the tangible goods they buy and sell.

For merchandiser (retailer/wholesaler) they purchases goods for sale, while the manufacturer makes or
produce them into a saleable product.

Service Organizations
A service company provides customers an intangible product. For example, accounting firms provide
audit and related services. Traditionally, labor costs were the most significant cost category for most
service organizations.
However, as information services become increasingly significant, this is changing. Some service firms
provide information, and for these firms, information technology can signify the main cost. Other firms
provide information analysis, and for these firms, labor costs will likely remain the most important
single cost.
____________________________ /nonmanufacturing costs/non-production/operating expenses are often
divided into two categories:
1. Marketing/selling expenses and
2. General and administrative expenses

Generally, all marketing/selling and general/ administrative expenses are treated as period costs. They
are recognized as expenses on the income statement in the period that benefits from the cost. Although
we are not directly concerned with financial statement preparation in this book, the cost accounting
system must be able to provide cost information for the financial reporting system.

For example, if a company pays for rental in advance for two years, the entire amount is not considered
an expense of the year in which the payment is made. Instead, one-half of the cost would be recognized
as an expense each year. The reason is that both years—not just the first year—benefit from the rental
payment. The unexpended portion of the rental payment is carried on the balance sheet as an asset
called prepaid rent.

Other examples are sales commissions, advertising, executive salaries, and public relations, are all
marketing/selling expenses (period costs). Marketing/selling expenses (period costs) are not included as
part of the cost of either purchased or manufactured goods; instead, period costs are expensed on the
income statement in the period in which they are incurred using the usual rules of accrual accounting.
Keep in mind that the period in which a cost is incurred is not necessarily the period in which cash
changes hands.
The matching principle is based on the accrual accounting concept that costs incurred to create
particular revenue should be recognized as expenses in the same period that the revenue is recognized.
________________________________________ include expenses incurred in the directing and controlling
the organization. Not all such expenses are allocated as administrative expenses. The salary of vice-
president in charge of manufacturing can be treated as a marketing expense. Other examples of
administrative costs include executive compensation, general accounting, secretarial, public relations,
and similar costs involved in the overall, general administration of the organization as a whole.
_________________________ begin at the point at which the factory costs end. That is, when
manufacturing has been completed and the product is in salable condition. Selling costs include all
costs that are incurred to secure customer orders and get the finished product to the customer. These
costs are sometimes called order-getting and order-filling costs. Examples of selling costs include
advertising or promotion, selling and delivery expenses, shipping, sales travel, sales commissions, sales
salaries, and costs of finished goods warehouses.

III. Costs in Relation to Manufacturing Department or Other Segments

A business can be divided into segments having any of a variety of names. The division of the factory
into departments, processes, work cells, cost centers, or cost pools also serves as the basis for classifying
and accumulating costs and assigning responsibility for cost control. As a product passes through a
department or cost center, it is charged with directly traceable costs (typically direct materials and direct
labor). And a share of indirect costs (factory overhead).
To achieve the greatest degree of control, department managers should participate in the development of
budgets for their respective departments or cost centers. Such budgets should clearly identify those costs
about which the manager can make decisions and for which the manager accepts responsibility.
At the end of a reporting period, the efficiency of a department and the manager’s success in the
controlling costs can be measured by comparing actual costs with the budget.
Producing and Service Departments
The departments of the factory generally fall into two categories producing department and service
departments.

In a producing department, manual and machine operations such as forming and assembling are
performed directly on the product or its parts. If two or more different types of machines perform
operations on a product within the same department, it is possible to increase the accuracy of product
costs by dividing the department into two or more cost centers.

In a service department, service is rendered for the benefit of other departments. In some cases, these
services benefit other service departments as well as the producing departments. Although a service
department does not directly does not directly engage in production, its costs are part of factory overhead
and are a cost of the product. Service departments that are common to many industrial concerns, include
maintenance, payroll, cost accounting, data processing, and food services.
In connection with materials and labor, the term direct refers to costs that are traced directly to a unit
of output; in the classification system, specific output is the cost object. The term direct and indirect
can also be used in connection in changing overhead costs to departments of any organization.

If a cost is traceable to the departments in which it originates, it is referred to as a direct department

cost; the salary of the departmental that benefit from its incurrence, it is referred to as an indirect
department cost; building rent and building depreciation are examples of indirect departmental costs.
in this cost classification system, the department is the cost object.

Service department costs also constitute indirect cost for other departments. When all service
department costs have been allocated, each producing department’s overhead will consist of its own
direct and indirect departmental cost and the apportioned charges from service departments.

External Financial Statements / Presentation of Costs in Financial Statements

For external reporting, the functional classifications for cost classification are normally used. In
preparing an income statement, manufacturing and non-manufacturing costs (operating
expenses) are separated.

The reason for the separation is that manufacturing costs are product costs—costs that are
inventoried until the units are sold - and the non-manufacturing costs of marketing and
administration are viewed as period costs. Thus, manufacturing costs attached to the units sold are
recognized as an expense (cost of goods sold) on the income statement.
Manufacturing costs attached to units that are not sold are reported as inventory on the balance sheet.
Marketing and administrative expenses are viewed as costs of the period and must be deducted each and
every period as expenses on the income statement.

Income Statement: Manufacturing Firm

Income computed by following a functional classification is frequently referred to as absorption-
costing system or full costing system because all manufacturing costs are fully assigned to the
product.
In absorption-costing system, expenses are separated according to function and then deducted from
revenues to arrive at operating income. The two major functional categories of expense are cost of goods
sold and operating expenses. These categories correspond, respectively, to a firm’s manufacturing and
non-manufacturing expenses.
__________________ is the cost of direct materials, direct labor, and overhead attached to the units sold.
To calculate the cost of goods sold, it is first needed to determine the cost of goods manufactured.
Cost of Goods Manufactured
The ___________________________ represents the total production cost of goods completed during the
present period. The only costs assigned to goods completed are the manufacturing costs of direct
materials, direct labor, and overhead. The details of this cost assignment are given in a supporting
schedule, called the statement of cost of goods manufactured.
Cost of Goods Sold
Once the statement of cost of goods manufactured is prepared, the cost of goods sold can be calculated.
The cost of goods sold is the manufacturing cost of the units that were sold throughout the period. It is
important to take note that the cost of goods sold may or may not equivalent to the cost of goods
manufactured. It should be noted, that the cost of goods sold is an expense, and it belongs on the income
statement.
Income Statement: Service Organization
Many service firms, such as those in financial services, have important transactions and billing functions
that use repeatable, discrete processes, not unlike many manufacturing processes. Because service firms
have no inventory to value, some firms have not taken steps to understand how these discrete processes
are associated with costs.

However, as competitive pressures force firms to become more efficient and effective, even service firms
have started to understand how important it is to associate costs and revenues with the distinct services
they provide so that they can better evaluate the value of the services being rendered.
Service firms are now adopting cost management practices that were originally developed in
manufacturing. For instance, banks and brokerage firms are using activity-based costing (ABC) and
distribution firms are using customer profitability analysis to disentangle selling, general, and
administrative (SG&A) costs.
The methods of cost analysis that were first developed in manufacturing are now being translated into
services to meet the universal demands for understanding costs as a part of strategic management of the
value proposition.
The income statement for a service organization looks very similar to the manufacturing organization.
However, the cost of goods sold does differ in some key ways:
1. The service firm has no finished goods inventories since services cannot be stored, although it is
possible to have work in process for services. For example, an architect may have drawings in
process and an orthodontist may have numerous patients in various stages of processing for
braces.
2. Some service firms add order fulfillment costs to the cost of goods sold.
External Financial Statements

The three sectors of the economy and provide examples of companies in each sector:
1. Manufacturing-sector companies
2. Merchandising-sector companies
3. Service-sector companies

Comparison of Service, Merchandising, and Manufacturing Business Sector

Business Product or Inventory
Sector Service Account(s) Examples
Manufacturing Physical products created by Finished Goods, Manufacturers of
the application of labor and Work in Process, automobiles, engines,
technology to raw materials Materials tape recorders, personal
computers, and
household appliances.
Some utility companies
such as gas, water, and
electricity
Merchandising Tangible products purchased Merchandise Bookstores, electronics
from suppliers in finished inventory stores, sports
form memorabilia shops,
beverage wholesalers
Service Intangible benefits such as None Accounting, medical, law,
accounting, health, legal, architectural, and
design and structural, engineering firms, hotels,
lodging, grooming, and hair stylists, sports
entertainment franchises

Comparing Service, Merchandising, and Manufacturing Sectors

Many similarities exist when we compare service, merchandising and manufacturing sectors.
Providing a service to a client in an accounting firm or repairing a air-conditioning unit in a
fix-it shop has strong similarities to manufacturing motorcycles in spite of different physical
and business settings.

In service sector, resources are brought together to provide the service, just as they are brought
together to create a product in a factory environment. Differences in measuring profits are
largely a function of inventoried costs.
 Service sectors have only supplies inventories.
 Merchandising sectors buy and sell products and hold merchandise inventories.
 Manufacturing sectors buy materials and convert these inputs saleable products.
Inventories here include yet-to-be-used materials, work in process inventory (partially
complete products), and finished goods inventory (completed and ready-to-sell products).

Income Statement: Service Sector

Several service sectors, such as those in financial services, have important transactions and
billing functions that use repeatable, discrete processes, not unlike many manufacturing
processes. Because service sectors have no inventory to value, some firms have not taken steps
to understand how these discrete processes are associated with costs.

Income Statement: Merchandising Sector

A merchandising business purchases product for resale. Generally, a merchandising firm is a
link the physical distribution chain, acting as a wholesaler or retailer. Figure 2.8 introduces
cost of goods sold to the income statement of supermarket, a retail grocery store. Again,
supporting the reported totals would be detailed revenues and costs of sales for various
segments such as produce, hardware, meat and grocery departments. Merchandise costs are
inventoriable or product costs, meaning that they are an asset until sold. All other expenses
in the supermarket operation are treated as period costs.

Income Statement: Manufacturing Sector

Manufacturing generally occurs in a factory, defined as a place where resources are brought
together to produce a product. Examples include: Soft-drink bottling company-mixing batches
and filling bottles of red pop; University dorm cafeteria-preparing and service food Print shop-
printing a variety of requests from customers Breakfast cereal manufacturer-processing grains
into “great” cereal. Automotive assembly plant-joining parts and subassemblies to create a
minivan. But, after some thought, you can see how many service firms really do “produce” the
service using our definition of a factory. Telephone company-processing local, long-distance,
and information calls Pharmacy-filling prescriptions; Tax return preparation firm-preparing
tax returns; Hospital surgery department-performing heart by-pass operations

Comparison of income statements and selected balance sheet accounts for the three sectors of
business: (assumed amounts)
Income Statements For 20x8
Service Merchandising Manufacturing
Sectors - Sectors - Sectors -
Anton Drei Cerise Kim Dorothy
Consultants Supermarket Products
Sales P8,000,000 P8,000,000 P8,000,000
- Cost of goods sold:
Cost of goods manufactured:
Purchases of direct materials P2,300,000
+ Beginning direct materials inventory 360,000
- Ending direct materials inventory (310,000)
Materials used P2,350,000
+ Direct labor 920,000
+ Manufacturing overhead 2,300,000
Total manufacturing costs P 5,570,000
+ Beginning work in process 320,000
- Ending work in process (340,000)
Cost of goods manufactured P 5,500,000
Purchases P7,000,000
+ Beginning finished goods inventory 510,000 600,000
- Ending finished goods inventory (480,000) (620,000)
Costs of goods sold P7,030,000 P 5,530,000
Direct client expenses 5,800,000
Gross margin P2,200,000 P 970,000 P 2,470,000
- Operating expenses:
Selling expenses P 610,000 P 550,000 P 980,000
Administrative expenses 1,270,000 260,000 1,030,000
Total operating expenses P1,880,000 P 810,000 P 2,010,000
Net operating income P 320,000 P 260,000 P 460,000
Selected Balance Sheet Information for 20x8
Accounts receivable P1,350,000 P 80,000 P 1,020,000
Materials inventory 310,000
Work in process inventory 340,000
Finished goods inventory 480,000 620,000
Accounts payable 220,000 110,000 460,000
Measuring Income in Service, Merchandising and Manufacturing Sectors